S&P 500 is Overstating the Market's Strength

Overbought/Oversold "Oscillator” is currently 89% oversold (Bullish/Neutral) which is 9% more oversold (Bullish) than the previous week. Last week the S&P 500 was up and it registered another new high. How is it possible for the market to be up and become more short term oversold at the same time?

One reason the Overbought/Oversold Oscillator continues to improve is because the Dow and S&P 500 are overstating the strength of the broader market. Technician and author David Vomund explains “The S&P 500, with its strength, is on an island. The large cap U. S. stocks are helped by the strong dollar; as a result, the S&P 500 is outperforming nearly all of the country funds as well as most domestic. Many broad-market stocks remain short-term oversold."

Case in point; the market was up last week…. or was it? The S&P 500 rose 1.2%, the NASDAQ was flat, and the Russell 2000 was down 1.2%. On one hand, the weakness in the broader markets is troubling but, our overbought/oversold indicator is now clearly Bullish.

Canterbury Volatility Index (CVI) is at CVI = 40 - (Bullish): Volatility, as measured by the CVI, has now tied the lowest level seen since the first quarter 2007. I am sure many of you are wondering about the possibility of a possible connection between the current extremely low CVI 40 volatility and the previous CVI 40 that preceded the financial collapse in 2008? Answer: No.

Today’s market environment is very different from the first quarter of 2007. During that time the lowest volatility reading reached CVI 35. This means that 2007’s (CVI 40) was preceded by increase volatility. A 14% increase to be exact.

It is important to note that the final S&P 500 peak was on October 9, 2007 up an additional 9.21% from date when the CVI was at 40. During that period, volatility had increased 140% from the low CVI 35 to CVI 84 (Bearish). This is a good example of how increasing volatility can be used as a leading indicator of future market declines.

As a point of reference, one of our studies evaluated daily market data going back to 1929. The purpose was to identify various volatility characteristics. The study showed that low volatility, as measured by a CVI 75 or lower, was considered to be a low risk market environment. It also showed that periods with low and decreasing volatility had smaller market corrections than periods with low but increasing volatility.

Market Sentiment: The American Association of Individual Investors (AAII) performs a weekly member survey that measures investor Bullish/Bearish sentiment. The periods when investors have a high level of optimism are actually Bearish.

Optimistic investors are typically fully invested. This means that there is little cash on the sidelines to fuel the market higher.

A high percentage of Bulls can become sellers when their expectations are not met.

Fully invested Bulls can only sell in the future and push prices lower.

On the other hand, a high percentage of Bears is Bullish

Pessimistic investors typically have high levels of cash

A high percentage of Bears can become buyers as their attitudes change.

A high level of cash, from Bears, is available for future buying to push prices higher.

In other words the AAII survey is an inverse indicator. A high percentage of Bulls is actually Bearish and a high percentage of Bulls is Bearish. This is why we are the most pessimistic at market bottoms and the most optimistic at market tops.

It is interesting to compare two periods, last Friday to first quarter 2007, when volatility was at an extreme low level (CVI 40). The record high of 75% Bulls, compared to 13% Bears, occurred near the January 2000 peak during the Dot-Com Bubble. The percentage of Bulls also hit its highest level on January 18, 2007, at 57.78% Bulls and 27.27% Bears. During that time the volatility was at CVI 40. In contrast, the current CVI 40 is occurring when the AAII survey is showing only 42% Bulls (Neutral).

Bottom Line: Last year’s leadership was more consistent. This year has had more rotations than normal. As the old saying goes “Bull markets will crawl a wall of worry.” It is amazing how concerned the financial press gets whenever the markets experience a couple down days or a normal correction. As discussed in the AAII survey, markets are counter intuitive. They will act opposite of what most will expect.

This morning’s weakness in most segments of the global equity markets is disconcerting. That said Bull markets, with the CVI below 75, are subject to corrections in the 4% to 8% ranges that can occur at any time.

Keep in mind that extremely low volatility will sometimes bring the "one day outlier” we have discussed many times in the past. Markets are supposed to move. Slow markets mean complacency among investors. Complacency will sometimes end with a knee jerk reaction to an unexpected short term event. The important point to remember is that such moves are just part of the random market noise and will have little impact on the overall trend.

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.